The Value Line Convertibles Survey

Convertibles As An Asset Class

Two months into 2008, and the “R” word (Recession) is being banded about on a regular basis. Although the technical definition of an economic recession is two consecutive quarters of negative GDP, many pundits, investment professionals, and even economists, are stating that although the preceding criteria have not been met, it certainly feels like a recession. Indeed, if the average man on the street were asked if they were in the midst of a recession, they would say yes. Dramatically reduced Federal Funds rate cut, and a huge $183 billion bailout plan (passed through the Senate in record time) are the monetary and fiscal tools being used to buoy consumer confidence and prevent major indices from falling further. Shell-shocked investors seeking safety have been looking at high-quality bonds and Treasuries. Yields on these instruments, however, are low. Convertible bonds, on the other hand, if chosen carefully, can be both risk free and generate relatively good returns.

Investors’ portfolios comprising only common stocks are not generally considered balanced. If one or more of the stocks on the equity side collapses, there is no downside protection to limit the fall except to sell the stock. But a balanced portfolio can dissipate much of that risk. Convertible bonds and convertible preferred stocks have a unique feature that offers support on the downside. A convertible’s fixed income value (or the bond portion of a convertible) acts as a floor—offering downside protection and limiting downside exposure to declines in the underlying stock. Indeed, this investing environment is suitable for convertible securities. Companies can sell debt that will cost less to service, and investors get to collect income and the option to exchange the debt for common stock at their convenience.

Historical studies show that on a total return basis, convertibles generally offer competitive returns to equities (though slightly lower depending on the time frame) with much less risk. As a result, on a risk-adjusted basis, convertibles offer one of the highest reward/risk ratios of all investment instruments. The traditional convertible bond or preferred stock is a hybrid instrument that can be broken down into two key components: a fixed-income debt instrument and a warrant on its underlying equity. The price at which a convertible trades is the combined value that the market places on both of these components. In addition, an issue’s fixed-income value or warrant value can be viewed as “floors” below which the convertible should not trade unless the market expects a change in the fundamentals of the underlying company (such as the investment rating of the company being downgraded.) These floors provide downside protection if either the equity or bond market moves against a position. Because most convertible securities have a yield advantage over the underlying equity interest, this advantage also provides a cushion against a decline in the underlying stock. Furthermore, although few convertibles have full participation in gains in the underlying common, the yield advantage that convertibles offer usually produces total returns over time that are very close to equities.

Convertible Basics

Conversion Value and Investment Value: Since convertible bonds or preferred stocks can be exchanged for the underlying stock, as the underlying equity’s price moves either up or down, a convertible can take on the features of an equity surrogate, a fixedincome debt instrument, or a combination of both. The key to a specific convertible’s exposure to movements in either its underlying equity’s price or interest rates in the fixed-income market is the relationship between the issue’s trading price and its conversion value and investment value. The conversion value of an issue is usually a straightforward calculation: the number of common shares for which the issue may be exchanged multiplied by the price of the common. This calculation will at times need to be adjusted; for example, in the case of a spinoff where an issue converts into more than one company or in the case of a stockplus- cash takeover. The investment value of an issue is its value as a straight, non-convertible debt instrument. In general, buyers of convertibles accept lower yields than those on straight debt instruments of the same company because the warrant (conversion privilege) gives holders a play on the underlying common with a chance to reap large returns. Issuing companies can acquire capital at a rate that is usually 1% to 2% below the interest or dividend rate that would have to be paid on a straight bond or preferred stock. As opposed to the conversion value, the investment value of an issue is much more difficult to calculate because it depends on a number of factors such as maturity, call risk, the issue’s investment grade, and whether or not the market anticipates the issue’s credit rating will be upgraded or downgraded. Subsequently, it is not unusual for analysts to have differing estimates of an issue’s investment value.

Premium over Conversion Value and Investment Value and an Issue’s Leverage Projections: Once an issue’s conversion value and estimated investment value are established, it becomes easier to understand why most convertibles will trade at a premium to these values. As mentioned, the typical convertible provides a higher yield than its underlying stock, and has a higher claim on assets and thus higher quality. Were the convertible to sell on its conversion value, sellers would be giving away the higher yield for free. (However, if an issue can be called to force conversion and the holders would lose accrued interest, the issue will often trade on conversion value less accrued because buyers must pay sellers the accrued when purchased, which would be forfeited if the issue were called.) On the other hand, if the issue were to trade on its investment value, sellers would be giving away the warrant value, the potential to benefit from a rise in the price of the common. As a result, a convertible will normally trade at a premium to both of these values.

A convertible’s premium over conversion value is simply the amount by which the price of the convertible exceeds its conversion value, most often stated as a percentage. Likewise, an issue’s premium over investment value is how much a convertible’s price exceeds its estimated investment value, again usually stated as a percentage.

As mentioned, an issue’s conversion value and investment value can be viewed as floors below which the issue should not trade unless the market is anticipating a change in the fundamentals of the underlying stock. Therefore, the relationship between an issue’s premium over conversion value and investment value will indicate how sensitive an issue is to either price changes in the underlying stock or to interest rates. A convertible’s leverage projection is based on this relationship and indicates the degree to which an issue should participate in equal up or down moves in the common, providing interest rates stay the same. Typically, convertibles will have favorable leverage, rising more than falling on equal corresponding moves in the underlying common stock.

Why Should I Consider a Buying a Convertible instead of the Common Stock?: If it could be predicted that a stock’s price will rise in the near term, then by all means, an investment in the common stock would more than likely yield a higher total return. However, equity markets rarely rise as spectacularly as they have over the last two years and are often volatile. Furthermore, in average years, where equity indices post gains of about 10% on a total return basis, it is not unusual to find the average convertible yielding higher returns due to the yield advantage.

As indicated, over time as a convertible’s underlying common price moves either up or down, the convertible will take on the characteristics of an equity surrogate, a straight bond or have sensitivities to both markets as its trading price will reflect the common’s movements and the shift toward either conversion value or investment value. Therefore, in terms of a portfolio’s objectives, convertibles cover a broad spectrum of investment alternatives from virtually pure fixed-income plays to pure equity plays.

All in all, the decision of whether or not to invest in either the common or the convertible will be unique to individual investors and their investment objectives. However, keeping in mind that, in general, convertibles are conservative investments that offer competitive returns to common stocks as well as downside protection, convertibles can be a welcome addition to any portfolio.

Prepared by
George S. Graham Editor